The November FOMC and the Election

The November FOMC meeting is scheduled for November 7 & 8, one day after the November 6 midterm election.

Federal Reserve - FOMC

We are not looking, then, at the possibility of any further FOMC action on interest rates that might influence the election one way or another, but what about after the election? Is the FOMC likely to increase rates another 25 basis points at this next meeting? Let us look at what information the FOMC will have next week.

The bulk of the economic data that has arrived since the last FOMC meeting is not only very positive but also consistent with the FOMC’s projections. On the inflation front, both of the FOMC’s preferred measures of inflation – headline inflation and the core Personal Consumption Expenditure Index (PCE) – actually declined in September, as the attached chart shows; and inflation now sits right on its target of 2%. More importantly, there are few signs of its accelerating. Energy prices have started to slow, and the rate of growth in housing prices has dropped below 6% for the first time in a year. Both of these components’ prices typically start accelerating as inflation pressures increase.

 

We see in the next chart that economic growth has shown unusual strength in the last two quarters, despite the negative impacts of the changing US tariff policies that have resulted in exports subtracting from real growth. Indeed, the last two quarters’ growth of 4.2% and 3.5% are the fastest the economy has grown since the third quarter of 2014. GDP also continue to outpace the Beige Book characterizations of growth. In the most recent Beige Book, four districts said that growth was modest (slightly below 2%); six said growth was moderate (slightly more than 2%); one said growth had increased slightly; and only one (Dallas) described growth as robust.”

Job-market data show a tight labor market, with more vacancies than unemployed people and an unemployment rate of 3.7%. Job growth, too, has been positive, with an average 208K jobs per month being added this year, as shown in the next chart. Today’s 250k jobs numbers continue the solid trend shown in the above chart. While these numbers look good, based upon recent history since the end of the financial crisis, they are more consistent with an economy growing at the rate of 2.2–2.4% and an economy growing at 3.5%–4.2%. Interestingly, if the economy today were creating jobs at the same rate it did between 1983 and 2006, the monthly jobs numbers would be twice what they are presently.

So with the economy on track with the FOMC’s projections and with no indications that inflation is accelerating, the FOMC can afford to stick with its projection for just one more rate hike this year. There is no planned press conference for the November meeting, nor will there be formal revisions to the FOMC’s Summary of Economic Projections. Given these facts, the chances are slim to none that there will be a rate hike next week.

Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


Source: https://fred.stlouisfed.org/


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David Kotok: Market norms are being restored; expect single-digit returns – Money Life (Radio)

David Kotok, Chief Investment Officer/Co-Founder, Cumberland Advisors, joins Chuck Jaffe on his program, Money Life, for an interview about what’s normal for financial markets, the Great Recession, thoughts on the volatility of October 2018, trade wars, and how does he see the year and the decade finishing out. According to Kotok, the market is getting back to normal, and while it might be some new normal, it will have the traditional long-term returns of 8 to 10 percent for large-cap domestic stocks and lower single-digits for bonds, and he noted that correcting expectations should help investors find satisfaction in the market ahead.

David-Kotok-Radio-Money-Life-Blue

LISTEN BELOW OR AT THE LINK HERE: https://www.youtube.com/watch?v=AX4zGksLNVU


 

If you like this interview, many more are to be had at the moneylifeshow.com website.

NOTE: Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.


If you like podcasts, check out this one from 2015 featuring David Kotok talking about his background and Camp Kotok with Barry Ritholtz. They also talk about the history of Cumberland Advisors since its founding, and delve into fundamental principles of investing and valuation.


Links here
https://itunes.apple.com/us/podcast/masters-in-business/id730188152?mt=2

And here
http://www.bloomberg.com/podcasts/masters-in-business/




Federal Reserve Independence – Under Attack Again?

The last few days, President Trump has made inflammatory and in some instances misguided remarks as to the nature of current Fed policy, its impact on the stock market and potentially on the economy.

Federal Reserve - Independence

Examples follow:

  • “It is a correction (the decline in the stock market) that I feel is caused by the Federal Reserve.”
  • “I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy.”
  • “I think the Fed is far too stringent and they are making a mistake.”
  • “The Fed is going loco and there’s no reason for them to do it.”
  • “I think the Fed is out of control.”
  • “I think what they are doing is wrong.”
  • The Federal Reserve is “my biggest threat,” President Donald Trump says.[1]

In the face of these comments, Larry Kudlow, director of the National Economic Council, tried to walk back the idea that the President has been attempting to influence Fed policy and indicated that the President was merely expressing an opinion.

Presidential effort to influence Fed policy are not new, nor are they unique to the present administration, especially during an election season. For example, the Reagan administration tried but failed to get Chairman Paul Volcker to commit to not raising interest rates in the midst of the 1984 presidential election. Similarly, with a slow economy in the election year 1992, President George H. W. Bush called on the Fed to cut interest rates, discounting concerns the Fed might have about inflation. Chairman Greenspan’s Fed did not cut rates and was seen by the President as the reason for his election loss and one-term presidency.

While these presidential attempts to influence have largely played out behind the scenes, the most egregious breakdown in Fed independence involving presidential pressure involved President Nixon and Chairman Burns in the early 1970s and it had significant negative consequences for the US economy, which played out through the end of the 1970s. Leading into the 1972 election, Chairman Burns willingly responded to the President Nixon’s pressure and manipulated FOMC policy decisions to stimulate the economy as it emerged from the 1969–1970 recession. The extent and nature of that pressure has been well documented due to the existence of the Nixon presidential tapes, which are now publicly available.[2]

In the aftermath of the 1969–1970 recession the federal funds rate declined steadily from 8.71% in January 1970 to 4.05% in January 1972, and the Fed’s discount rate was reduced from 6% to 4.5% over that period. However, at the same time, unemployment continued to increase despite an improving economy, rising from 3.9% in January 1970 to between 5.6% and 6% in the late summer and early fall of 1972.[3] Nixon was concerned about being a one-term president; and on October 10, 1971 (Conversation No. 607-11), he quipped, “I don’t want to go out of town fast.” The text of the discussion and tape played recently on national television clearly suggests that Nixon had only a rudimentary understanding of the economy or monetary policy. A month later, in another conversation, Burns reported that earlier that day (November 10, 1971) the Fed had reduced the discount rate, indicating that this stimulus would help buoy the economy. Thereafter, Burns continued to engineer additional policy stimulus and reported to Nixon on December 10, 1971, that the discount rate had been lowered ahead of the upcoming FOMC meeting and that Burns’ intention was to prod the FOMC into even more accommodative action. He stated that he aimed to “put them on notice that through this action that I want more aggressive steps taken by the Committee on next Tuesday.”[4] Burns went on to state that “Time is getting short. We want to get this economy going.”

What these and subsequent conversations clearly document is that in late 1971 and into 1972 the administration continued pressuring the Fed to expand the money supply to stimulate the economy.[5] Burns was a willing participant, effectively subordinating the Fed to presidential pressure and engaging in a rapid expansion of the money supply. Nixon not only employed jawboning but also had George Shultz put Burns on notice that appointments to the Board would be closely controlled.[6]

Burns and his tightly controlled FOMC delivered on an expansionary policy. Not only were policy rates dropped during 1972, but the Fed also engineered a very rapid increase in both the M1 and M2 money supplies. M1 growth increased from 4.51% in 1970 to 6.7% in 1971 and then to 7.56% in 1972, while M2 growth exploded even more, from 7.36% in 1970 to 11.65% in 1972. That growth continued after the election, and quarterly M1 growth was between 6.4% and 8.4% during all of 1972, while quarterly M2 growth, shown in the attached chart, ranged between 11.7% and 13.2% that year.[7]


Federal Reserve Independence – Under Attack Again - M2 Growth Chart
 

While the Burns stimulus clearly helped Nixon win the election in November 1972, the seeds were sown for a disastrous inflation. That inflation occurred with a lag, in part because President Nixon imposed a 90-day freeze on wages and prices in August 1971 that was subsequently extended to April 1974. The result was stagflation; and as the controls were gradually dismantled, prices began a disastrous climb. The money supply increases slowed gradually through 1973 and briefly bottomed out before accelerating again. The ensuing inflation continued until Chairman Volcker engineered a recession and broke the back of inflation.

The common feature of the three presidential attempts to induce the Fed to pursue expansionary policies all occurred a year or so before a national election and followed a recession and slow recovery. None of these conditions exist presently. The economy has been growing steadily, albeit slowly, since 2008. Inflation is at the FOMC’s 2% target, unemployment hasn’t been this low since the 1960s, job openings exceed the number of unemployed and wages have finally started to increase. As for policy, even with eight 25-basis-point increases in the federal funds target range, the Chicago Fed’s National Financial Conditions Index shows that conditions are as accommodative as they have been since the start of the recovery. Finally, with less than a month to the election, there is no action the FOMC could take that would impact the economy before the election.

This president may, as a real estate developer, like low interest rates; but that may not be in the best interests of the economy, despite his recent assertion that he knows more than the Fed does. His claim that the Fed caused the recent stock market decline, cited in the quote at the beginning of this commentary, ignores the fact that this decline and the previous decline early in 2018 followed on the heels of the announcements of the imposition of tariffs and the declines are unlikely to be related to Fed policy moves. Jawboning the Fed but not really interfering with its independence may have an advantage. Kane(1980) argues that by leaving the Fed with a fair amount of “… ex ante discretion, elected officials leave themselves scope for blaming the Fed ex post when things go wrong.” Perhaps in anticipation of the 2020 election, this may be what the President means when he sees the Fed as his biggest threat. Fortunately, in the meanwhile Chairman Powell is secure in his position, and the members of the FOMC understand the dangers of subordinating policy to the political whims of this or any other White House.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] https://www.cnbc.com/2018/10/16/trump-says-fed-is-his-biggest-threat-because-it-is-raising-rates-too-fast.html
[2] What follows relies upon Burton Abrams, “How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes,” Journal of Economic Perspectives, Volume 20, Number 4, Fall 2006, pp. 177–188.
[3] See Abrams (2006), Table 1.
[4] See Abrams (2006), Conversation No. 16–82.
[5] Edward J. Kane, “Politics and Fed Policymaking: The More Things Change the More They Remain the Same,” Journal of Monetary Economics, Vol. 6,(1980) pp 199-211 argues that as William McChesney Martin departed the Fed and Author Burns became chairman that the money supply assumed greater importance as a tool of monetary policy.
[6]Abrams(2006), Conversation 17-5.
[7] Source: FRB St. Louis FRED database


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




ASX plunges after US bloodbath

Excerpt below:

The Australian share market has plunged by more than 2 per cent in early trading following a bloodbath on Wall Street overnight. At 10:15am AEDT on Thursday, the ASX200 index was down by 122.5 points to 5,927.5.

It came after Wall Street stocks plunged Wednesday, with major indices losing more than three per cent in a sell-off prompted by the sudden jump in US interest rates and increasing trade worries.

“Fear is rising,” says chief investment officer at Cumberland Advisors David Kotok. “Investors are getting a wake-up call.”

Read the full article at The Queensland Times.




Doc Holliday, Jay Powell, Donald Trump & The Piano

“Ready, Fire, Aim”?

In Understanding and Managing Public Organizations, Hal Rainey makes the point that “the intangible issues of culture, values, human relations – matters that many managers regard as fuzzy and unmanageable – can and must be skillfully managed.” The contrary approach, which is favored by many companies and government agencies, can be summarized as “ready, fire, aim.” (Understanding and Managing Public Organizations, https://books.google.com/books?isbn=0787980005)

 

Market Commentary - Cumberland Advisors - Please do not shoot the pianist. He is doing his best

Rainey’s insight will prove relevant as we consider this week’s stock market carnage.

Politico offered this explanation for the carnage:

“WHY MARKETS TANKED AND WHAT’S NEXT — The real surprise is it took this long. Wall Street has been shrugging off a rising 10-year yield, fear over the trade war with China and uncertainty surrounding the midterm election for way too long. The S&P 500 did not record a single move up or down of 1 percent by the closing bell in the third quarter. That hasn’t happened since 1963, according to LPL Financial.

“That kind of calm is what’s abnormal, not the 3 percent decline in the Dow and S&P on Wednesday and the 4 percent decline in the Nasdaq. President Trump blamed the drop in part on the Fed, saying the central bank had ‘gone crazy.’ He also referred to a ‘a correction we’ve been waiting for,’ which is a much better explanation.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Now, in order to assist the fact checkers, here is the full Trump quote:

“The Fed is making a mistake. They’re so tight. I think the Fed has gone crazy. So you could say that, well, that’s a lot of safety actually, and it is a lot of safety, and it gives you a lot of margin, but I think the Fed has gone crazy.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Here’s our take.

The (in)famous Doc Holliday (https://www.historynet.com/spitting-lead-in-leadville-doc-hollidays-last-stand.htm) occasionally played the piano at the legendary Silver Dollar Saloon in Leadville, Colorado. When Oscar Wilde appeared at the Tabor Opera House across the street, he would cross the street to the saloon for a drink or two after his lectures. Wilde noted that there was a sign over the piano that read: “Please do not shoot the pianist. He is doing his best.” (Source: a personal visit to the legendary Silver Dollar Saloon)

The sign over the piano could apply to today’s Federal Reserve. The Fed now has over a 100-year history. It is doing the best it can. Let’s not shoot it.

At the recent NABE conference, Fed Chairman Powell said,

“This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.”

He added that “The economy is seeing a “remarkably positive outlook … and a modest steepening of the Phillips curve would be unlikely to cause a significant rise in inflation or demand a disruptive policy tightening. Once again the key is anchored expectations.” He welcomed the recent rise in wages and stated, “Higher wages alone need not be inflationary.” We thank Mike Englund and his team at Action Economics (www.actioneconomics.com) for capturing Powell’s quote with precision.

There is a lot of Fed-related jawboning about the recent employment report. Many folks argue that it was distorted by hurricane effects, so we need another month to gain clarity. With Hurricane Michael now added to the natural disaster list, we may hear the same chorus when the October data is compiled and released.

Meanwhile, the inflation outlook is coupled with the question of whether or not wages are trending upward and accelerating. And the negative economic effects of the Trump-Navarro trade war are only beginning to show up in the data. On a positive note the new NAFTA agreement with Canada and Mexico has reduced anxiety in markets and seems to have stabilized a trending deterioration in sentiment. That improvement (the situation is now less worse than expected) may offset the impact of the US-China lack of progress. Without a directional policy change, the China-US imbroglio could prove very serious. The fears that we articulated in our Thucydides Trap pamphlet are sadly being realized. (The pamphlet is available here in PDF form: “Lessons from Thucydides,” https://www.cumber.com/pdf/Lessons-from-Thucydides.pdf.)

Of course, for the investor the issue is, what does all this mean for future Fed policy and interest rates?

The Treasury yield curve has abruptly steepened. We expected that to happen, given the one-time influence of a special tax provision that expired in mid-September. See “Why the Yield Curve Is Flat and Why It May Steepen,” https://www.cumber.com/why-the-yield-curve-is-flat-why-it-may-steepen/. And we looked to the high-grade muni curve for some guidance. See “The Tale of Two Ratios: Shorter and Longer,” https://www.cumber.com/the-tale-of-two-ratios-shorter-and-longer/. The pricing of munis is set mostly by high-income American investors. The muni curve was steep and continues to be so. Treasury yields result from investments by both Americans and foreigners – a blend of influences. Thus the muni curve may be a better source of high-grade forecasting power. We think it deserves some respect.

So what about wages and inflation?

We updated our series of Beveridge curves. Nearly all of them point to a wage acceleration coming. (We will send any reader the 8-chart series if you provide us with a full snail-mail address.) That series depicts specific unemployment rates crossed with other indicators like job openings or quits. It tracks the last expansion period, the Great Recession and financial crisis, and the recovery since. When viewed together, the curves make a compelling case for an acceleration of the upward trend in wages and for rising inflation. Beveridge curves tell you Fed Chairman Jay Powell may soon see his “historically rare pairing” appear more normal.

My friend Michael Drury at McVean Trading had this comment following on his observation that “Wages have grown at a 3.2% apace over the past 11 months.” He expects 3.2% to continue and notes that “3.2% means wages are compensating workers for 2% inflation and 1.2% productivity growth.” Meanwhile, other economists argue about that productivity growth and ask, “Where’s the beef?”

My friend and fishing buddy Danny Blanchflower is a labor economist and ardent student of Keynes and Beveridge. Danny is a Dartmouth professor of economics, Bloomberg contributor, former Bank of England board member, and serious academic researcher. He and I have discussed the concept of NAIRU, the non-accelerating inflation rate of unemployment – in other words, the level of unemployment below which inflation rises. (For more on NAIRU see https://en.wikipedia.org/wiki/NAIRU.)

NAIRU is not observable, so it has to be estimated. Danny notes that there were periods in history when the estimate for NAIRU was as low as an unemployment rate of 1 to 2%. He cites Keynes and Beveridge for that history. He also notes how central bankers routinely miss on their estimates of NAIRU. That means they are playing the saloon piano when it isn’t tuned.

Danny uses something he calls the U-7, which quite simply is the U-6 unemployment rate minus the U-5 unemployment rate. He is trying to find a marginal shift that signals the turning point where NAIRU is reached and the upward pressure from accelerating wages influences inflation. If we use his back-of-the-envelope approach (he has serious research on this), we can estimate that NAIRU may be as low as a 3% unemployment rate, given the present structure of the US labor force. (For a full description of the various US unemployment rates and the methods of data collection, see “How the Government Measures Unemployment,” https://www.bls.gov/cps/cps_htgm.htm.) Furthermore, as the national statistics gravitate toward this 3% NAIRU estimate, regional and state statistics are tending to confirm the trend. Great work on the state data is performed by Philippa Dunne and Doug Henwood. I suggest serious readers check out the October 4th edition of TLR on the Economy. If you are interested, send me an email with your contact information, and I will ask Philippa to send you a copy of that research.

We have taken Danny’s U-7 concept and developed some measures and estimates of the impact of the changes in the U-7 on things like the Consumer Price Index, average hourly wages, and JOLTS (the job openings portion of the labor data). What we are seeing in every series is a trend toward rising wages and rising inflation. It is hard to discern the exact month of acceleration in these series, but there seems to be some consistency. We will send any reader who gives us a snail-mail address a set of our U-7 charts. Researchers now have a road map if they want to develop their own statistics.

Let’s sum this up after we thank those journalists and friends and colleagues cited here. Please remember that anyone who is writing and publishing publicly is under repeated attack these days, as the Constitution’s First Amendment protections seem threatened by political forces unlike those we have seen in American history in recent decades.

We think the president’s attack on the Fed was wrong. It hurts his political party. It hurts the country. And it helped tank the markets. The Trump-Navarro US-China trade war is worsening, and markets don’t like it. Markets now fear that Trump has undone the beneficial effects of his repatriation policy, tax cuts, and deregulation initiative. What started out on a positive path is now a war between the two largest economies of the world. That war now seems to be intensifying. Remember: In a shooting war the guns are pointed at each other; in a trade war the guns are pointed inward. Nobody wins.

The warning on the saloon piano was apt. Don’t shoot the player who is doing his best. (And especially don’t try to shoot the player if it is Doc Holliday.)

Mr. President. You will do what you want. That is continually made very clear by your behavior. The country will determine who is loco. And history will report the results.

We are allocated toward domestic weights in our US ETF managed accounts. We have a cash reserve. We are in a correction.

Positions in portfolios can change at any time.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Dow drops 800 points, led by tech shares, as stock market investors fear higher rates

Cumberland-Advisors-David-Kotok-In-The-News

Excerpt below:

The Dow plunged more than 800 points Wednesday, its worst drop in eight months. Rising bond yields have been drawing investors out of the stock market. The best-performing stocks over the past year took some of the biggest losses.

Growing concerns about the impact of higher borrowing costs on corporate earnings and consumer spending prompted investors to dump shares.

“Fear is rising,” says David Kotok, chief investment officer at Cumberland Advisors in Sarasota, Florida. “Investors are getting a wake-up call.”

Kotok went as far as to predict that a full-fledged market “correction,” or drop of 10 percent, is underway. After its drop of more than 3 percent Wednesday, the broad U.S. market, as measured by the Standard & Poor’s 500, is now 4.9 percent off its Sept. 20 record high.

Read the full article at USA Today.




The Danger of Rising Bond Yields, and the Opportunities

Cumberland-Advisors-David-Kotok-In-The-News

The Danger of Rising Bond Yields, and the Opportunities

Excerpt below:

The 10-year Treasury note was yielding 3.24% in midafternoon trading on Wednesday, just below the seven-year high reached Monday, when the 10-year Treasury yield hit 3.25%, buoyed by Friday’s unemployment report showing the jobless rate at its lowest level in 49 years. By day’s end the 10-year Treasury yield had retreated to 3.19%, below the 3.21% close on Tuesday, but the major U.S. stock market indexes were off more than 3% from the previous close.

Traders cited rising Treasury yields, escalating U.S. trade war with China and a recent IMF warning on global growth, including U.S. growth, for the decline, which was led by large-cap tech stocks like Apple and Google.

“Markets are repricing risks,” says David Kotok, chief investment officer at Cumberland Advisors. “Bottom line, rates have to go higher to really zonk markets, but markets are now starting to realize that there is an upward trend in interest rates, that there there is some rising, accelerating inflation, and that the Fed is being placed between a rock and a hard place by Trump because they have to contend with the growing effects of the Trump-Navarro trade war.” Peter Navarro is one of the top trade advisors in the administration.

Kotok notes that investors can now collect 5% yield on federally guaranteed mortgage-backed securities, 4%-plus yield on very high grade tax-free bonds, and 2% on cash equivalents. And with expectations that yields may go even higher, based in part on the Fed signaling more rate hikes this year and next, some bond buyers are stepping to the sidelines while other bondholders and stockholders “don’t need a lot of encouragement to sell on the heels of huge bull markets in both for many years.”

Read full article here: www.ThinkAdvisor.com




The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


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Fed staff research anchors subtle shift that could lead rates higher

Reuters Wednesday August 29, 2018 18:42
Excerpt of: Fed staff research anchors subtle shift that could lead rates higher
by Howard Schneider

WASHINGTON  – The U.S. Federal Reserve should be ready to lift interest rates for a longer period or even more quickly than currently expected to insure against a jump in inflation in a U.S. economy operating in the vicinity of full employment.

That is the message that has been percolating up from senior central bank staff economists to policymakers including Fed Chair Jerome Powell in research that has helped inform a subtle shift in how Powell plans to steer policy amid growing uncertainty about concepts such as full employment and the neutral level of interest rates.

Powell on Friday signaled he was wary of how accurately the Fed can estimate some of the variables that are important to the U.S. central bank’s models of the economy, including the level of full employment and the “neutral” rate of interest, and was thus hesitant to be guided strictly by how they interact.

“A skeptic would say that the models aren’t working – and this is what Powell is indirectly saying,” Robert Eisenbeis, chief monetary economist with Cumberland Advisors, wrote this week. “His answer is to fall back on risk management,” or weighing the cost of a mistake in either direction and choosing the less costly option.

Read the full article at Reuters.com




How Good Can It Get?

Friday’s GDP release showing growth at 4.1% is clearly positive news. Consumer spending contributed 2.7 percentage points to growth, followed by fixed investment (0.94 percentage point largely offset by a negative 1.0 percentage point contribution from inventories) and a 1.06 percentage point contribution from net exports.Market Commentary - Cumberland Advisors - GDP 4.1 How Good Can It GetIf we factor this growth figure together with a PCE inflation now at 2.3%, a strong job market (230K jobs were created in June), and unemployment at 4%, the FOMC now appears to have a strong case to make another rate hike, even though the next meeting, on July 31–August 1, is not one where new projections will be offered or a press conference scheduled.

Naysayers will argue that this growth rate can’t continue and that 4.1% is clearly above potential. For example, exports are up, and some have suggested that the surge has occurred because companies anticipate looming tariffs. The administration, on the other hand, is arguing that we haven’t seen anything yet when it comes to growth. Well, the question is, can 4.1% be repeated the next couple of quarters? First, let’s look at a bit of history. The chart below shows the quarterly real GDP growth rate (annualized) since 2005 – before the financial crisis and the period following the crisis, when we have seen slow productivity growth.

Over that period there have only been 6 out of 50 quarters where growth has been over 4% (four at slightly over 4% and two at 5% or more). In nearly each case, the following quarter was in many instances about 2%, and growth continued to stay well below 4% for many quarters thereafter. Only one exception exists when growth was over 5% (Q1 2014) followed by growth over 4% (Q2 2014) the next quarter.

One of the reasons for a reduction in the rate of growth following a strong quarter during the 2005-2018 Q2 period is the fact that potential growth is actually much less and 4%, and people argue that this remains the case going forward. The Congressional Budget Office, for example, puts potential growth at 2.3%.

How might we rationalize that number? The two key determinants of potential GDP growth are the rate of growth of productivity and rate of growth of the labor force. Abstracting from sophisticated analytical techniques, productivity growth from 2007 through Q3 2016 was about 1.1% (1). BLS employment projections suggest that the labor force will grow about 0.6% over the next 10 years or so. Add those two numbers together, and we get a sustainable growth rate of slightly less than 2%. Now, if the positive economy brings more people into the labor force – i.e., the participation rate increases – and the investment stimulated by the tax cut continues, then we may see potential GDP about where the CBO has it. But the prospect for large, sustainable increases in GDP growth is at this point problematic.

So, while the Q2 GDP number is extraordinary and the economy is basically strong, we are not likely to see a continuation of such robust growth, especially if the tariff and trade wars continue. Furthermore, the FOMC is going to be focused on inflation, which is now running 16% above its 2% target rate.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


(1) See https://www.bls.gov/opub/btn/volume-6/below-trend-the-us-productivity-slowdown-since-the-great-recession.htm.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.